Increasing human life spans have operated to create new challenges for the elderly and for existing infrastructures that support the elderly population. Members of the aging population are faced with the possibility of outliving their financial resources and therefore seek mechanisms that will guarantee financial independence. Accordingly, financial instruments have become available for providing long term financial security.
Corporate pensions and insurance company annuities, which are frequently utilized by the elderly contain significant interest rate, inflation, and longevity risks for the providers of such products including life insurers and pension plans. Under favorable market conditions in which high equity returns are realized, pension plan providers may not suffer from the impact of longevity improvements. However, as market conditions deteriorate and poor equity returns prevail, pension plan providers are impacted by the longevity improvements that have occurred over time. Furthermore, life insurers providing annuities face risks due to unanticipated changes in mortality rates.
To combat the risks mentioned above, pension plan providers and life insurers can attempt to transfer or hedge longevity risk. Longevity bonds are among the financial instruments that have developed and provide a form of insurance for betting against outliving savings through mortality rates. Longevity bonds pay a coupon that is proportional to the number of survivors in a selected birth cohort. If the cohort is defined, for example, as the number of individuals turning age sixty-five in the year that the bond is issued, the coupon the following year would be proportional to the number in the cohort that survive to the current year. Since this payoff approximately matches the liability of annuity providers, longevity bonds can theoretically be used to create an effective hedge against longevity risk.
However, a number of issues arise with the trading of mortality linked securities. Such issues may be related to the liquidity, basis risk, and credit risk. In order to make the securities attractive to hedgers, liquidity and low basis risk are desirable. In order to enhance liquidity, the design of the security should be transparent such that risks and potential returns are predictable. Furthermore, the reference population should be based on data from a reliable public source. Ultimately, in order to create a liquid market in mortality linked securities, the designed securities must be attractive for both buyers and sellers.
Thus, when providing payments linked to a survivorship index, it is important to implement an accurate predictive model. As stated above, pension funds and annuity providers face growing risks due to the increasing life spans as they may have guaranteed fixed or variable payments for a life span that has become unexpectedly lengthy. Thus, the longevity risk created by increasing life spans in conjunction with interest rate risk has caused problems for the annuity market. As annuity markets continue to grow, the risks and consequences of underestimating mortality improvements also continue to grow. Accordingly, a solution is needed for enhancing the predictive accuracy of the longevity bond model in order to further reduce risks.
Furthermore, in some instances, for example when a bond is issued by a government or government sponsored entity, the yield on the bond is too low to attract investors. Thus, investors have been reluctant to accept currently existing structures for issuing longevity bonds. The combination of the low yield and an imperfect demographic structure failing to adequately define a cohort for predictive accuracy have been deficiencies of previously attempted longevity bond systems. Thus, a solution is needed for providing a structure for issuing a longevity bond that will operate based on a demographically sound index and generate a sufficiently high yield for attracting investors.